islm - Monetary Theory ISLM and Monetary Policy Policy...

Monetary Theory ISLM and Monetary Policy Policy Makers (IMF, US Treasury) can use the ISLM model to determine what happens to interest rates and output when they increase/decrease the money supply. Before we continue, we look at factors that cause the IS and LM curves to shift. · Factors that cause the IS curve to shift A change in the interest rate or aggregate output will cause a movement along the IS curve. Changes that cause the expenditure function to shift cause the IS curve to shift. · Changes in autonomous consumption e.g. increase in confidence about the economy, changes in wealth, etc · Changes in investment spending (unrelated to the interest rate) e.g. increase in business confidence, changes in technology, etc · Changes in government spending · Changes in taxes · Changes in Net Exports (unrelated to the interest rate) e.g. changes in taste, trade policy, etc · Factors that cause the LM curve to shift A change in the interest rate or aggregate output will cause a movement along the LM curve. Changes that cause the M D or M s curves to shift cause the LM curve to shift. Y 1 Y 2 Y 3 i 1 Y 1 Y 2 Y 3 IS IS' Y 1 AD =exp Y 2 AD =exp2 Y 3 AD =exp3 IS" An increase in G, I, NX, and a shifts the expenditure Y AD function up. For a given interest rate, i 1 , the IS curve shifts to the right ! increase in equilibrium income. An increase in T shifts the expenditure Y AD function down. For a given interest rate, i 1 , the IS curve shifts to the left ! decrease in equilibrium income.

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· Changes in the money supply When the money supply decreases, the LM curve shifts left for a given income, Y 1 . Why? When the money supply falls, M s <M D . People sell bonds, price of bond falls and interest rate increases. Since output does not change, the LM curve must shift to the left as the interest rate rises to satisfy money market equilibrium. · Changes in money demand (not related to the interest rate or income)

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